Federal Funds Rate and My Finances

Lately there has been a lot of talk about the federal funds rate. This is something that dominates headlines whenever there is a change in this rate. Most recently the Federal Reserve made a huge rate drop. The 1st drop was 3/4ths of a percent, then shortly after by another ½ percent bringing the rate all the way down to 3%. Why such the hype? How does this affect individuals finances?

What is the Federal Funds Rate?

The federal funds rate is the interest rate that banks lend balances to other depository institutions, usually overnight. This rate is the rate that banks can borrow from the Federal Reserve, or in other words, it is the lowest possible rate that banks can charge on interest. Changing this rate is one of the primary tools that the Federal Reserve uses to regulate the supply of money in the US economy.

The Effect of lowering the Federal Funds Rate

By lowering the rate, borrowing becomes cheaper for banks and with competition among the banks they will pass this savings onto their customers. This will make borrowing cheaper for individuals because the rate at which banks can lend is less and the default risk also goes down because there is not as much interest to pay by the individual. The purpose of lowering the Federal Funds rate is to create a domino effect that will eventually stimulate the economy. The cycle it is suppose to follow is this: the Federal Reserve lowers rates, banks lower rates, individuals will borrow more money, the borrowed money buys goods, the sellers of the goods make more money and deposit into banks, banks have more money to lend, then repeat this cycle and the economy is stimulated.

What this means to most individuals in the near and distant future?

This will help out many individuals with their credit card interest rates because the prime rate, which directly influences credit card interest is highly correlated to the Federal Funds rate. From the domino effect, credit card lenders are also able to obtain a lower borrowing rate and therefore competition will force them to decrease their rates. This is one thing that individuals that carry balances on their credit card should be aware of because sometimes the lender will keep charging the same rate. An individual who is aware of this can most of the time, contact the credit card company and demand a lower rate.

The lowering of the federal funds rate will also decrease the interest earned in savings accounts and in CDs. This can force many individuals to seek better investment options for their funds because the interest earned in savings accounts and CDs is very minimal, most likely not even enough to keep up with inflation. This can also be good for the stock market because this can cause higher demand for publicly traded stocks, therefore driving up the prices and increase returns. (Also returns can go up from the domino effect created from the dropping of the fed rate, which also explains why there is a sudden surge in stock prices when there was an unexpected decrease of the federal funds rate)

One misconception about the fed lowering the Federal Funds rate is that it directly influences mortgage rates. Mortgage rates are much more complex in how they are determined than just by the Federal Funds rate. Mortgage rates are based on long term rates, while federal funds rate is a short term rate. Mortgages are priced like the stock market, if there is a expected drop in the federal funds rate, the mortgage rate will price it into the rate before the rate drop even happens. An unexpected rate drop can influence mortgage rates, but only by a small amount. The fed rate is an indirect factor in determining the long term rates. Even though it is only a small indirect factor, long term interest rates are very low right now and locking in a safe, low fixed rate at the current time may be a good idea.

Overall, the rate cut is a good thing for credit card interest and other short term loans, but on the negative side, savings accounts will not earn as much interest. If all goes as planned the economy will get the extra boost it needs to stay out of a recession, while also indirectly making a positive influence on long term interest rates and keeping inflation in check.